Chicago’s fiscal headache

Chicago has nearly identical fiscal challenges to its home state of Illinois: pension underfunding, massive school deficits and recurring deficits. But unlike the state, many of the decisions that need to be made in Chicago are out of the control of leaders, especially related to pensions. These decisions are made in the state legislature. Chicago Mayor Rahm Emanuel seems to have had little success lobbying for the city’s interest. Chicago political writer Greg Hinz described it in Crain’s Chicago Business last year:

In a rare mayoral visit to Springfield, Rahm Emanuel today told lawmakers that they need to act now on pension reform for government workers, and he laid out some specifics as to what he wants.

Testifying before a House committee, Mr. Emanuel called for a 10-year holiday on paying cost-of-living increases in Chicago’s four pension funds and other government retirement systems around the state. That freeze would apply to both current workers and those who already have retired.

Workers also ought to contribute an additional 5 percent of salary to keep their defined-benefit pensions, he said. The increased contribution would be phased in over five years.

Despite Emanuel’s efforts, nothing has been accomplished in Springfield for pension reform. The House and Senate proposals for the state were not as far-reaching as Emanuel had proposed for Chicago. The big money challenge for the state is its pension liabilities.

Fitch announced last week that it has placed the city’s rating on negative watch, which is a prelude to a potential ratings downgrade. The rating drivers were all about lack of pension reform:

The Rating Watch Negative reflects Fitch’s growing concern over both near-term and long-term risks associated with the large and growing unfunded pension liability. These concerns overshadow recent improvement in other aspects of the city’s credit profile.

LONG-TERM RISKS: The unfunded liabilities recorded in the city employees’ pension funds continue to rise without a corresponding increase in funding. The combined reported funding ratio for the four plans has declined steadily, reaching a low 35.2 percent at Dec. 31, 2012. Fitch estimates the funding ratio to be a weaker-still 32.9 percent, assuming a more conservative 7 percent rate of return.

NEAR-TERM RISKS: Any solution to the funding problem would likely involve a very large increase in the annual contribution, as current statutorily-based contributions seriously underfund the actuarially required contribution (ARC). The amount that would be required to amortize the unfunded liability grows larger as time passes, both in nominal terms and as a percent of governmental spending, threatening to crowd out other city spending priorities.

MANAGEMENT’S OPTIONS LIMITED: The current administration has attempted to address the pension liability through direct negotiation with labor unions and by lobbying the state legislature, which ultimately controls the benefit formula; neither approach has succeeded thus far.

Here is the skinny from Fitch:

Any changes to the [pension] benefit structure would require an act of the state legislature, which is currently struggling to address its own pension funding issues. Fitch also notes that Illinois law affords strong legal protection to pension benefits and expects that any such changes would face legal challenges.

Any solution to the pension funding problem is likely to require significantly higher annual contributions from the city. Fiscal 2011 carrying costs for pension, OPEB and debt service would have amounted to a high 31.4 percent of governmental fund spending if the ARC were fully funded; well above the 17.6 percent burden under the current statutorily-based payment structure.

As Marc Joffe, former Senior Director at Moody’s Analytics, noted in his study of the history of Illinois’ defaults, a government entity spending over 30 percent of revenues on pensions, other post-employment benefits (OPEB) and interest is threatening default. Given Chicago’s dire fiscal straits, Emanuel might want to take up residence in Springfield. Convincing state legislators to give Chicago some pension relief is the only path to salvation.